This Wall Street magic trick makes stocks appear cheaper than they are By: Mark Hulbert | July 23, 2018
Valuing the S&P 500 on estimated 2019 earnings is pure speculation — or worse
Some Wall Street analysts are playing games with the S&P 500’s price/earnings ratio.
These analysts are calculating the S&P 500’s SPX, -0.09% P/E ratio on the basis of what they think corporate earnings will amount to in the coming calendar year. Nowadays, that means their P/Es are based on 2019 earnings — a number that won’t actually be known for another 20 months or so.
Such calculations are profoundly speculative, needless to say. Think about all the things that could sabotage analysts’ estimates. The still-nascent global trade war could escalate and bring about a worldwide recession, for example. Geopolitical tensions could break out on the Korean peninsula, in Europe, or Russia — to name three current hotspots. How confident can you be in estimating the S&P 500’s earnings-per-share in 2019?
This focus on 2019 earnings is conjecture enough, but these same analysts compare forward-looking P/E ratios with historical P/Es that are calculated on the basis of actual, as-reported (i.e. trailing) earnings. Since forward-looking P/Es are invariably lower than ratios calculated based on trailing earnings, their comparisons make the market look less overvalued than it really is.
To be sure, forward-looking P/Es are always speculative. But at some times of the year the extent of analysts’ forward-looking focus is the next 12 months. In the summer, focusing on the next calendar year expands considerably the extent of speculation.
Contrast how analysts calculated forward-looking P/Es in January of this year with how they do so today. At the beginning of this year, most forward-looking P/Es were based on forecasted earnings for calendar 2018 — the subsequent 12 months, in other words. Today, in contrast, many analysts have shifted to calendar 2019 when calculating forward-looking P/Es — a period that won’t even begin for another six months, won’t end for another 18 months, and not be known until earnings season ends during the first quarter of 2020.
How big a difference does it make to extend one’s speculative horizon so far into the future? To estimate I went through two steps.
Step 1: Past versus future
The first step was to measure the historical difference between P/Es based on trailing earnings, next-12-month earnings, and earnings measured over the 12-month period that begins two calendar quarters hence. The table below shows the medians of these three different P/Es since 1965.
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